Chapter 8 Cash and Receivables

331

CONCEPT REVIEW
1. What are the advantages of the net method of recording cash discounts?
2. Explain the computation of the annual rate of interest for cash discounts lost.
3. What are the advantages and disadvantages of the two approaches to the allowance
method of accounting for bad debt expense?

USE OF ACCOUNTS
RECEIVABLE TO
OBTAIN IMMEDIATE
CASH

Factoring Accounts
Receivable

Companies frequently sell or use their accounts receivable as collateral to secure loans. The
objective is to obtain more immediate access to cash. Sales of accounts receivable (also
called factoring), assignment, and pledging are common forms of nancing.19 The original holder of the accounts receivables is called the transferor (in factoring), the assignor
(in assignment), or the pledger (in pledging). Similarly, the company providing the cash is
called the transferee, assignee, or pledgee, respectively, and is usually a nance company
or bank.
Using receivables to obtain nancing effectively shortens the operating cycle, hastens
the return of cash to productive purposes, and alleviates short-run cash-ow problems. The
costs of these arrangements include initial fees and interest on loans collateralized by the
receivables. Also, certain risks may be retained by the transferor, including bearing the cost
of bad debts, cash discounts, and sales returns and allowances.
Agreements to transfer accounts receivable are made on a recourse or nonrecourse
basis. In recourse nancing arrangements, the transferee can collect from the transferor if
the original debtor (customer) fails to pay. If the arrangement is without recourse, the transferee assumes the risk of collection losses. The fee is higher under nonrecourse arrangements because more risk is transferred.
Agreements are made on either a notification basis (customers are directed to remit to
the new party holding the receivables) or a nonnotication basis (customers continue to
remit to the original seller). Factoring arrangements are usually made on a notication basis.
The key nancial reporting issue in a receivable nancing arrangement is whether the
transaction is a sale or a loan. In a sale, the transferor removes the receivables from the
books and records a gain or loss. In a loan, the receivables remain on the transferors books,
and a liability is recorded. Generally, recording a sale is preferred, especially if a transferors total debt is already substantial.
Factoring transfers ownership of the receivables to the transferee (the factor). In some
instances, the factor performs credit verication, receivables servicing, and collection
agency services, in effect taking over a companys accounts receivable and credit operations. Other factoring arrangements are less inclusive.
Factoring is common in the textile industry and in retailing. Suppliers to apparel retailers, department stores, and discount retailers prefer not to risk shipping merchandise without assurance that a factor will purchase the resulting receivables. The diagram below
depicts the relationships among the parties.
Steps in Factoring Receivables

SUPPLIER
(Transferor)

Cash
(4)

Accounts receivable
(2)
Merchandise
(1)

Accounts
Receivable (3)

RETAILER

Cash
(5)
FACTOR
(Transferee)

19

Among companies surveyed in 1998, 20 percent reported entering into some form of nancing arrangement involving receivables. See Accounting Trends and Techniques (New York: AICPA, 1998), p. 210.

332

PART II ASSET RECOGNITION AND MEASUREMENT

The factor plays a key role in the continuance of the business relationship between suppliers and retailers. The factor charges a fee in return for accepting the risk of default by
retailers. If that risk increases, the factor will increase the fee, reduce the amount of receivables purchased, or suspend credit to the suppliers.
Example Factors typically are willing to fund most or all of the receivables from a healthy
retailer. In February 1996, Kmart Corporation was rumored to be considering ling for
bankruptcy. Factors were funding only 60 percent of the receivables of Kmarts suppliers,
down from 80 percent three months earlier. In addition, factors raised the premium charged
to 3 percent, up from one-half percent.20
Factoring without Recourse A nonrecourse factoring arrangement generally constitutes an
ordinary sale of receivables because the factor has no recourse against the transferor for uncollectible accounts. Control over the receivables generally passes to the factor. The factor typically assumes legal title to the receivables, the cost of uncollectible accounts, and collection
responsibilities. However, any adjustments or defects in the receivables (sales discounts, returns,
and allowances) are borne by the seller-transferor because these represent preexisting conditions.
The receivables are removed from the transferors books, cash is debited, and a nancing fee is recognized immediately as a nancing expense or loss on sale. The factor may
hold back an amount to cover probable sales adjustments. This amount is recorded as a
receivable on the sellers books.
Example Largo, Inc., factors without recourse $200,000 of accounts receivable with a
nance company on a notication basis. The factor charges a 12 percent nancing fee and
retains an amount equal to 10 percent of the accounts receivable for sales adjustments.
Largo does not record bad debt expense on these receivables because, in nonrecourse transfers, the nance company bears the cost of uncollectible accounts. The entry to record the
transfer is:
Largo, Inc.
Cash $200,000  (.12  .
.10)$200,000 . . . . . .
Receivable from factor . .
(.10)$200,000 . . . . . .
Loss on sale of receivables
(.12)$200,000 . . . . . .
Accounts receivable . . .

.
.
.
.
.
.

Finance Company
Accounts receivable . . . .
Payable to Largo . . . .
Financing revenue . . .
Cash . . . . . . . . . . .

156,000
20,000

.
.
.
.

200,000
20,000
24,000
156,000

24,000
200,000

Largos loss equals the nance fee. This amount is also the book value of the receivables factored less the assets received from the nance company ($200,000  $156,000
 $20,000). As customer sales adjustments occur, Largo records these deductions in the
proper contra sales accounts and credits the receivable from the factor. After all adjustments
are recorded, any excess in the receivable is remitted to Largo. If adjustments exceed the
amount withheld by the factor ($20,000 in this case), either the nance company or the
seller absorbs this amount as a loss or the two parties agree to allocate it in some other
manner.
The remaining entries are based on the following additional information concerning the
factored receivables:
a. $2,000 of estimated and actual bad debts.
b. $4,000 of cash discounts.
c. $12,000 of sales returns and allowances.

Therefore, customers remitted $182,000 ($200,000  $2,000  $4,000  $12,000) to the

nance company. The nance company records customer collections, reduces the payable
to Largo by the amount of actual sales adjustments ($16,000), records bad debts, and settles with Largo.
20

Kmart, in Letter, Seeks to Calm Vendors on Prots, The Wall Street Journal, February 16, 1996, p. A3.

Chapter 8 Cash and Receivables

333

Largo, Inc.
Sales returns and allowance
Sales discounts
Receivable from factor
Cash ($20,000  $4,000  $12,000)
Receivable from factor

Finance Company
12,000
4,000

Bad debt expense

2,000
Allowance for doubtful accounts

2,000

16,000
4,000
4,000

Allowance for doubtful accounts 2,000

Accounts receivable
2,000
Payable to Largo
16,000
Cash
182,000
Accounts receivable
198,000
Payable to Largo
4,000
Cash
4,000

Credit Card Operations Although bank credit card companies such as VISA and MasterCard are not factors, their operations are similar in many respects. Two benets accrue
to the merchant who accepts credit cards. First, the merchant receives immediate cash on
sales that otherwise would be made on credit (or not made at all). Second, unless the merchant prefers to maintain its own credit card operation in addition to accepting national
cards (which many department stores do), the merchant saves the cost of customer screening and servicing functions.
Normally, a merchant accumulates credit card sales in batches, depending on volume.
Credit card vouchers are deposited with a bank acting as agent for the credit card company,
and the amount remitted is discounted by the credit card company. Assume that a merchant
accumulates $2,000 in credit card sales. The discount fee is 6 percent. The appropriate entry
at the time of deposit is as follows:
To deposit credit card vouchers:
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Credit card fees expense (.06) ($2,000) . . . . . . . . . . . . . . . . . . . . . . . . . .
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1,880
120
2,000

If sales are posted daily with deposits made less frequently, a receivable is debited, rather
than cash.21
Factoring with Recourse When receivables are factored or otherwise transferred with
recourse, the transferor bears the risk and cost of bad debts. The nance company has recourse
against the transferor in the event of default by the original customer. Whether a sale or a
loan should be recorded by the transferor is less clear than it is in nonrecourse arrangements,
due to the continuing involvement of the transferor with the transferred receivables.
A transfer of receivables or other nancial assets is accounted for as a sale only if the
transferor surrenders control over the assets transferred, and only to the extent that consideration other than a benecial interest in the receivables is received. A benecial interest is
a right to receive cash ows from the receivables. If the transferor retains a benecial interest, the transferee may be unable to sell the assets, implying that control has not been completely relinquished by the transferor.
The transferor has surrendered control if, and only if, each of the following three conditions of SFAS No. 125, Accounting for Transfers and Servicing of Financial Assets and
Extinguishments of Liabilities, is met:
1. The transferred assets have been isolated from the transferorput beyond the reach of
the transferor and its creditors.
2. The transferee has the right to pledge or exchange the assets, free of conditions that constrain it from taking advantage of that right.
3. The transferor does not maintain effective control over the transferred assets through an
agreement that (a) both entitles and obligates the transferor to repurchase the assets or
(b) entitles the transferor to repurchase assets that are not readily obtainable.

21

Some banks and credit card companies sell their receivables to other parties. Banc One Corporation of Columbus, Ohio, is credited with starting the securitization of credit card accounts. In 1986, it sold $50 million of its credit card receivables as securities.
See The Wall Street Journal, Centennial Issue, June 23, 1989, p. A2.

334

PART II ASSET RECOGNITION AND MEASUREMENT

The recourse obligation, by itself, does not prevent the recording as a sale. Nor does an
option held by the transferor to repurchase the receivables necessarily require recording the
transfer as a loan.
For the rst condition to be met, neither the transferor nor the creditors of the transferor
(e.g., in the event of the transferors bankruptcy) can retain a claim to the transferred receivables. Further, the transferor cannot retain the right to revoke the transfer.
The second condition operationalizes the SFAC No. 6 denition of an asset in the context of factored receivables. If the transferee can sell or pledge the receivables without interference from the transferor or other parties, then the transferee has control over the future
cash ows underlying the receivables, as a result of a past transaction.
The third condition pertains to a requirement that the transferor repurchase the assets
or to an option to repurchase the receivables (a call option). If the transferor must
repurchase the assets (common in repurchase agreements), control has not passed to the
transferee.
In the case of an option, the transferor may wish to reacquire interest-bearing receivables, for example, when interest rate changes would be favorable to the holder of the
receivables. Although an option to repurchase the receivables may, at rst, seem to imply
that control has not passed to the transferee, the option does not entitle the transferor to
receive interest or other benets from the transferred receivables. The transferor does not
have custody of the assets, does not control the disposition of the asset, and cannot access
the asset unless the option is exercised.
However, the transferee must be in a position to fulll the option, if it is exercised. The
transferred assets, or similar assets, therefore must be readily obtainable. If assets were not
readily obtainable, then the transferee would be constrained by the call option, would not
be able to sell the assets, and would not effectively control the assets. Thus an agreement
allowing the transferor to repurchase such assets would effectively maintain control with
the transferor.

Cash Flows

Transfer Accounted for as a Sale If the transfer of receivables meets the above three conditions, the transferor records the transfer as a sale of receivables. The transferor derecognizes the assets sold (removes the asset from the balance sheet) and recognizes any
recourse liability. A gain or loss is also recognized by the transferor:
Proceeds from transfer  Consideration  Recourse
received
liability
Gain or loss on transfer  Proceeds  Book value
from
of receivables
transfer
If the proceeds exceed the book value, a gain results, and vice versa. The transferee recognizes all assets received at fair value.
Transfer Accounted for as a Loan If the transfer does not meet all three conditions, the
transfer is accounted for as a secured borrowing. In this case, the transferor maintains the
receivables on its books, records a liability, and recognizes interest over the loan term.
The lender (transferee) maintains a security interest in the receivables (the receivables are
used as collateral).
If the transferee is not permitted to sell or pledge the collateralized receivables unless
the transferor defaults, the transferor continues to carry the assets on its books as previously classied. However, if the transferee is permitted to sell or pledge the assets, the
transferor must reclassify the receivables and report them separately from other receivables.
Example Largo, Inc., factors with recourse $200,000 of accounts receivable with a nance
company on a notication basis. Accounting by Largo for both a sale and a loan is illustrated. The nance companys entries are similar to the previous nonrecourse example.
Assume the nance company charges 6 percent (less than in the nonrecourse example) and

Chapter 8 Cash and Receivables

335

Largo estimates its recourse liability for bad debts to be $3,000 (bad debts have not yet
been recorded).
Largo, Inc.
Recorded as a Sale
Cash
Loss on sale of receivables
Accounts receivable
Recourse liability

Recorded as a Loan

188,000
15,000*
200,000
3,000

Cash
Discount on payable to factor
Payable to factor

188,000
12,000
200,000

* .06($200,000)  $3,000

In the sales example, the proceeds to Largo equal $185,000 ($188,000  $3,000), the
difference between cash consideration received and the recourse liability. The loss is the
difference between the proceeds and the book value of the receivables and includes the estimated bad debts. The recourse liability is classied as current or long-term depending on
the expected date of payment for defaulted accounts.
In the loan example, the discount account, a contra payable account, represents interest
(the factors fee) over the term of the loan. Interest expense is recognized on the balance
of the payable to factor, which declines as customers make payments.
The remaining entries record payment of the recourse liability for defaulted accounts in
the sales example. In the loan example, the payable to factor is extinguished as customers
pay on account. Also shown are the recognition of bad debts and interest expense.
Largo, Inc.
Recorded as a Sale
Recourse liability
Cash

Recorded as a Loan
3,000
3,000

Bad debt expense

3,000
Allowance for doubtful accounts

3,000

Allowance for doubtful accounts 3,000

Accounts receivable
3,000
Payable to factor
200,000
Accounts receivable
197,000
Cash
3,000
Interest expense
12,000
Discount on payable to factor
12,000

In the loan example, assume that Largo recognizes interest expense in proportion to collections on accounts receivable. That proportion is a measure of the expired portion of the
loan term. If, for example, $20,000 of the accounts remained uncollected (10 percent of the
total factored) at the end of the period, only $10,800 of interest expense (.90  $12,000)
would be recognized in the above entry.
Estimation errors are expected in factoring. For example, if bad debts were underestimated (say, by $2,000), Largo would record an additional $2,000 loss and remit an
additional $2,000 of cash to the factor in the sales example. In the loan example, bad debt
expense would increase $2,000, as would the amount paid to the factor. If bad debts were
overestimated by $2,000, Largo would recognize a $2,000 gain in the sales example, remit
only $1,000, and reduce the recourse liability $3,000. In the loan example, only $1,000 of
bad debts would be recorded, and only $1,000 would be remitted to the factor.
Sales Adjustment The previous example assumed no sales returns and allowances or cash
discounts. As in nonrecourse factoring, sales adjustments reduce the cash obtained by the
transferor from nancing the receivables. The factor may hold back a part of the proceeds
to protect against such adjustments.
Example Assume the basic information in the Largo recourse example above and (1) the
factor holds back $10,000 for returns and allowances, and (2) actual returns and allowances
amount to $6,000. The entries for both a sale and a loan treatment are:

336

PART II ASSET RECOGNITION AND MEASUREMENT

Largo, Inc.
Recorded as a Sale
Cash
Receivable from factor
Loss on sale of receivables
Accounts receivable
Recourse liability

Recorded as a Loan

178,000
10,000
15,000*
$200,000
3,000

Cash
Receivable from factor
Discount on payable to factor
Payable to factor

178,000
10,000
12,000
200,000

*.06($200,000)  $3,000

Sales returns and allowances

Receivable from factor

6,000

Recourse obligation
Cash
Receivable from factor

3,000
1,000*

6,000

4,000

*Excess of hold-back over actual

sales returns and allowances
$10,000  $6,000
Cash owed factor under recourse
obligation

$ 4,000

Net cash to Largo

$ 1,000

3,000

Bad debt expense

3,000
Allowance for doubtful accounts

3,000

Allowance for doubtful accounts

Accounts receivable

3,000
3,000

Sales returns and allowances

Accounts receivable

6,000

Payable to factor
Cash
Accounts receivable
Receivable from factor
Interest expense
Discount on payable to factor

Assignment and Pledging of

Accounts Receivable

6,000
200,000
1,000
191,000
10,000
12,000
12,000

Assignment and pledging entail the use of receivables as collateral for a loan. An assignment
of accounts receivable requires the assignor to assign the rights to specic receivables. Frequently, the assignor and the nance company enter into a long-term agreement whereby the
assignor receives cash from the nance company as sales are made. The accounts are assigned
with recourse; the assignee has the right to seek payment from the specic receivables.
The assignor usually retains title to the receivables, continues to receive payments from
customers (nonnotication basis), bears collection costs and the risk of bad debts, and agrees
to use any cash collected from customers to pay the loan. A formal promissory note often
allows the assignee (lender) to seek payment directly from the receivables if the loan is not
paid when due.
The loan proceeds are typically less than the face value of the receivables assigned in
order to compensate for sales adjustments and to give the assignee a margin of protection.
The assignee charges a service fee and interest on the unpaid balance each month.
The receivables are reclassied as accounts receivable assigned, a separate category
within accounts receivable used to disclose their status as collateral. The subsidiary accounts
are also reclassied to indicate their use as collateral, for internal accounting purposes. The
loan balance is reported among the assignors other liabilities.
Example Assume that on November 30, 2001, Franklin Corporation assigns $80,000 of
its accounts receivable to a nance company on a nonnotication basis. Franklin agrees to
remit customer collections as payment on the loan. Loan proceeds are 85 percent of the
receivables less a $1,500 at-fee nance charge. In addition, the nance company charges
12 percent interest on the unpaid loan balance, payable at the end of each month.
Accounts receivable assigned is a current asset listed under accounts receivable in the
balance sheet. All entries are for Franklin.
To record receipt of loan proceeds:
Cash .85($80,000)  $1,500 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Finance expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Notes payable .85(80,000) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

66,500
1,500
68,000

To classify accounts receivable as assigned:

Accounts receivable assigned . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

80,000
80,000